AN ANALYSIS OF EXCHANGE RATE CHANGES ON FOREIGN AID IN PAKISTAN

Abstract

This article investigates the long run and short run effect of exchange rate changes on foreign aid of Pakistan by applying unit root and cointegration analysis. The data set includes annual observations for the period 1973-2010. Moreover, this study examines four alternative but equally plausible hypotheses, each with different policy implications. These are: i) foreign aid cause Real Exchange Rate (the conventional view), ii) Real Exchange Rate cause foreign aid, iii) There is a bi-directional causality between the two variables and iv) Both variables are causality independent (although highly correlated). The empirical evidence finds significant positive relationship between exchange rate changes and foreign aid in long run, as well as in short run. Both in the long and short run, foreign aid is affected by exchange rate changes. The impact of foreign aid on development of different country has always been a controversial issue. Rich countries used foreign aid for productive purposes like encourage the domestic investment and industrial development. Empirical studies suggest that aid has not performed significantly on economic growth. Khan (1997) finds inverse causal effect of aid-growth, while Ishfaq and Ahmed (2005) find out that economic growth of Pakistan has remained totally independent of foreign aid. The large amount of inflows of foreign aid to Pakistan could not be associated for the development purposes. During the 1990s an increase in foreign aid in the form of loans has created the foreign debt problem in the country. (Khan and Ahmed, 2007) Many economists stress that foreign aid is sufficient and necessary condition for the growth in developing countries. They claim about the positive correlation between economic growth and foreign aid because it fills the gap between the resources which provide the finance to achieve the short term targets. The contribution of foreign aid in the growth process and return to capital in the developing countries has been a topic of great debate. Foreign aid is a main topic with regarding to poverty reduction in developing countries. The important role of foreign aid is enhancing the economic growth. The benefits of aid have currently been under severe conditions. Several researchers argue that a large amount of foreign aid flowing from developed to developing nations is de-utilize and increases unproductive public consumption. These results are often cited due to poor institutional development, inefficiencies, bureaucratic failures and corruption in the developing countries (Alesina and Dollar, 2000). Economists are in broad favor that where policies and institutions are relatively robust, aid can have a positive impact on economic growth. However, there is much less agreement on the impact of aid where institutional failure is high. (Heineken, 2008)

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